Contract Services in 2012

The year 2011 ended with the buyout of the contract research organization (CRO) Pharmaceutical Product Development (PPD) by two private-equity firms, the Carlyle Group and Hellman & Friedman. They paid $3.9 billion, a 30% premium over the company's value shortly before the deal was announced, making it the largest private-equity deal for a publicly traded CRO.

Clinical CROs such as PPD have proven to be popular takeover targets for private-equity firms: PharmSource counts at least eight publicly owned CROs that have been taken private by private-equity firms since 2003 (see Table I). One CRO, PRA International, had a roundtrip. It was founded as a private company, taken public by its private-equity investor, Genstar Capital, in an initial public offering (IPO) in 2005, and then taken private again by Genstar in 2007.

MANAGEMENT INCENTIVES

Private-equity buyouts are usually quite attractive to the current shareholders of the company because they offer a significant premium over what the company's stock was selling for shortly before the deal was announced. These deals are usually even more enticing to the senior executives who run the acquired company for two big reasons. Going private allows executives to pursue long-term growth strategies away from the oversight of public shareholders and Wall Street analysts, both of which may be more interested in short-term results than initiatives that promise longer-term, but more uncertain, payoffs. As importantly, the private-equity buyers usually offer the senior executives increased equity stakes in the company that can deliver great riches if those executives are successful in substantially increasing the value of the company through the successful implementation of those long-term strategies.

The PPD deal illustrates how senior management's frustrations with the public market can drive a company's board to pursue a private-equity buyout. In the past decade, the company had pursued a strategy it called "compound partnering" under which it would acquire or invest in promising early-stage drug candidates. PPD would undertake the early-development efforts to establish proof-of-concept, then out-license or sell the candidate to a drug company for late development and commercialization. Despite some early successes, the stock market and analysts following the company were uncomfortable with this strategy because it introduced a level of risk and uncertainty into a valuation model that expected steady financial performance that was easy to forecast. As a result of the uncertainty, the market discounted the value of the company's stock. A similar problem had been a major reason for another CRO, Quintiles, to undertake a management-led buyout in 2003.

PPD's board tried to improve its stock's performance by making its compound-partnering business into a separate company, which it spun off to shareholders in 2010. That move, however, did not help the stock's valuation as much as had been hoped. Part of the problem had been the underperformance of PPD's laboratory services business, whose disappointing profitability in recent years has been blamed for depressing the company's stock price.

Private ownership may enable PPD management to address the laboratory businesses' problems with a long-term view while shielding it from second-guessing by public investors. That was the story at PharmaNet Development, which was bought by a private-equity firm after it was cited for noncompliant behavior in running some of its clinical trials.